Hiring independent contractors offers flexibility and potential cost savings for businesses. However, there’s a legal minefield in misclassifying workers, which can result in significant financial penalties, back pay, and legal liabilities. Below, we explain why correct classification matters, the current federal and state legal tests, and practical steps you can take now.
Why Misclassification Is Costly
Misclassifying a worker as an independent contractor when they meet the criteria for employee status can trigger liability under the Fair Labor Standards Act (FLSA), IRS regulations, and state labor laws. Employers may owe back wages (including overtime), penalties, taxes, and interest, not to mention potential class-action suits and damage to reputation.
Employee or Independent Contractor?
Courts and U.S. Department of Labor use the economic realities test to determine whether a worker is truly in business for themselves (Independent Contractor) or is economically dependent on the employer and therefore an employee under the Fair Labor Standards Act (FLSA).
This test examines the totality of the circumstances by looking at several key factors, including the degree of control the employer has over the work, the worker’s opportunity for profit or loss, the level of investment made by the worker, the permanence of the working relationship, the degree of skill required, and whether the work is integral to the employer’s business. No single factor is determinative, and the analysis focuses on the actual working relationship, not just the language of a contract
State Laws and the ABC Test
Some states, most notably California under AB 5, apply the ABC test. Under this stricter standard, independent contractor status is valid only if all three conditions are met: no control by the hiring company, work performed outside the usual business and customarily engaged in an independent trade or business. The state’s aggressive enforcement makes classification audits essential.
Consequences for Businesses and Workers
Misclassified workers may lose out on minimum wage, overtime, unemployment insurance, workers’ compensation, anti-discrimination protection, and Social Security contributions. For employers, misclassification can result in audits, fines, litigation costs, and exposure to stop-work orders in certain jurisdictions.
Steps to Stay Compliant in 2025
First, conduct a thorough audit of all independent contractors using both federal and state standards, including economic reality and ABC tests. Ensure contracts accurately reflect real-world practice and limit direct control over contractors’ schedules, tools, and training. Encourage contractors to maintain separate business operations, serve multiple clients, invest their own capital, and handle their taxes independently. Finally, reassess arrangements regularly to reflect evolving legal standards.
Conclusion
Worker classification is increasingly scrutinized in 2025. To protect your business from costly penalties and foster compliant working relationships, contact Romano Law today for a comprehensive contractor classification audit and custom guidance informed by the latest federal and state developments.
Contributions to this blog by Kennedy McKinney.
